Why Europe's Banks Trail in Deleveraging Process

By

Simon Nixon

Updated March 26, 2012 8:07 a.m. ET

Almost five years after the start of the global financial crisis, the U.S. banking system has just been given a virtually clean bill of health. The Federal Reserve has withdrawn its unconventional liquidity measures to support the banking system; banks are now funding themselves normally in private markets and lending is flowing freely again. Only four out of 19 large banks failed the latest Fed stress test; the rest are now free to resume dividends, boosting bank stocks. Compare that with the euro zone, where much of the banking system remains on life support, reliant on funding from the European Central Bank, whose balance sheet has grown to record levels, and where lending growth is weak.

How does one explain such a marked divergence? The conventional wisdom is that the U.S. was far quicker to tackle the problems in its banking system, recognizing losses and injecting fresh capital, ensuring banks quickly regained investor confidence. But this doesn't give a complete picture. Parts of the euro-zone banking system may still be undercapitalized and the market is putting pressure on banks to comply with the new Basel rules early. But it is hard to argue the recent European Banking Association stress test was too easy: Banks are required to hold 9% core Tier 1 capital on a Basel 2.5 basis after marking sovereign bonds to market prices; the recent U.S. stress test only required banks to hit a 5% Tier 1 threshold on a Basel 1 basis—a far less demanding target.

Almost five years after the start of the global financial crisis, the U.S. banking system has just been given a virtually clean bill of health. Heard on the Street's Simon Nixon says that the U.S. banking has an inherently better sector. Photo: Reuters

Indeed, if one compares the capital strength of the U.S. and European banking systems on a Basel 3 basis, they are very similar. The differences only emerge when one looks at total balance sheets. The ratio of tangible equity to total assets at U.S. banks is around 6%, almost double that of European banks. That reflects big differences in the composition of their balance sheets, with U.S. bank assets considered more risky and therefore attracting higher risk weights under the Basel process than those of European banks. Of course, it may be those risk weights are wrong and that the entire Basel framework lacks credibility; the zero risk weighting for government debt is one frequently-cited anomaly. But unless one believes that all bank assets should be treated as identically risky, a comparison of total balance sheet leverage is not particularly helpful.

Besides, this focus on capital may be a distraction. The real difference between the U.S. and European banking systems lies in their funding structures. Put simply, a far higher proportion of U.S. loan books are funded by deposits. The U.S. market has a loan to deposit ratio of 78% compared to more than 110% in Europe. European banks have a total funding gap of $1.3 trillion ($1.72 trillion) which they need to finance in wholesale markets, estimates Simon Samuels, a banking analyst at Barclays Capital. But if European banks were funded the same way as U.S. banks, they would have a deposit surplus of $3 trillion.

This difference in funding structure is an accident of history. The shape of the U.S. industry has been defined by its response to previous crises. The Great Depression in the 1930s led to the creation of Fannie Mae and Freddie Mac, the government-sponsored mortgage agencies, which transferred the bulk of U.S. housing finance off bank balance sheets and onto that of the Federal government. Meanwhile the savings and loans crisis of the 1980s accelerated the growth of the corporate capital markets. As a result, U.S. banks provide less than 30% of U.S. mortgage funding and 30% of corporate funding. In the euro zone, banks provide 80% of mortgage debt and up to 90% of corporate loans. Unlike the U.S., capital market funding to the European economy is mediated via the banks.

This difference is exacerbated by regulation: U.S. banks continue to be regulated under Basel I, which limits the size of bank balance sheets relative to their equity. But European banks, on the other hand, have been regulated under Basel II, which jettisoned the total leverage ratio in favor of carefully calibrated risk weights for every exposure. As a result, The result was that U.S. banks have been incentivized to load up on risky assets that offered the highest returns at the lowest leverage, while European banks were incentivized to load up on less risky assets with low regulatory capital requirements, enabling them to maximize leverage. "That's why European banks love mortgages and U.S. banks like leveraged loans, why European banks like Triple-A and U.S. banks like Double-B," says Mr. Samuels.

The question for European policy makers is whether the European banking model is now permanently broken as a result of the crisis—as the U.S. banking model was broken by the crises of the 1930s and 1980s. Or is the current refusal of markets to fund parts of the European banking system a temporary phenomenon that will pass once the sovereign debt crisis eases? There's some reason to hope the latter: While there is little correlation between bank capital ratios and funding costs, there is a strong correlation between the cost of bank funding and government funding. For example, BBVA, one of the best capitalized banks in Europe, must pay far more for bond market financing than Deutsche Bank, one of the euro zone's most thinly capitalized banks.

But what if funding markets don't recover? The ECB's Long-Term Refinancing Operations bought time, providing banks with cheap three-year loans to replace lost bond market financing. But if time doesn't prove a great healer, the euro zone will face unpalatable choices. It could try to create a U.S.-style system, reducing high bank LDRs by encouraging far greater use of capital markets. But this may require the creation of euro Fannie and Freddie, surely a political non-starter. Or it could brace itself for a repeat of Japan's experience with banks continuing to deleverage until LDRs reach U.S. levels—a process that could take six years and would require them to shed up to €4.5 trillion of assets, reckons Morgan Stanley. Or the ECB could continue to fund the shortfall with yet more LTROs. But that would mean the European banking system remaining in intensive care for years—and doubts over the health of the economy never fully going away.

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